Thursday, July 7, 2011

This chart of nearby copper futures shows how prices have jumped in the past week, confirming that the recent rally in equities and the selloff in Treasuries have been driven by improving growth fundamentals. Dr. Copper (so-called for its ability to detect and reflect the changing dynamics of economic growth and monetary policy) has been on a tear since early 2009, with a few pauses along the way which coincided with periods during which the market had deep concerns about the risks of a double-dip recession.

Markets are feeling better about the prospects for growth even as yields on 2-yr Greek debt and the prices of Greek credit default swaps continue to show a very high likelihood of a significant Greek restructuring/default. So the Greek debt tail is not likely to wag the global economic dog. Economic activity is likely to continue to expand, albeit at a relatively slow pace.

Major supply issues from Africa and South America. China is currently building a super highway system connecting 60 cities and 700million people. Most of the world's supply of metals & materials will be necessary for the next few years.

"Take copper financing by lenders in China. This is an example of an inverted balance sheet. As the biggest consumer of copper, China largely sets global copper prices. If China is growing quickly, this tends to push up the price of copper, and lenders who are secured by copper see the value of their loans increase – they become more secure. The lenders of course are delighted. They are probably making good money because China is growing, and on top of it their loans are becoming more secure than ever.

Of course this changes if the Chinese economy were suddenly to slow, especially if it slows sharply. In that case the lenders would probably see their revenues decline at the same time as the value of the collateral supporting their loans declines. If their borrowers are then forced to liquidate the collateral in order to repay the loans (which is likely to happen if the economy slows sharply), the liquidation value could easily be less than the value of the loans. In that case China would see an unsustainable rise in its debt – and notice this always happens at exactly the wrong time.

It is important to remember this when thinking about financing risks in China. We often hear analysts argue that because China has little consumer financing and because mortgage margins are high, they don’t have a debt problem. This argument is about as useless as the claim that because China has large reserves it is unlikely to have a financial problem. The limited consumer and mortgage financing in China means that china will not have a US-style financing problem, and the large amount of reserves means that China won’t have a Korean-style financing problem, but no one has ever seriously argued that those are the kinds of risks China faces. What matters is the level of debt, whether or not its growth is sustainable, and the kinds of contingent structures that are embedded. I would argue that all three measures are worrying."